This year has seen a continuance
of the high and increasing level of activist campaigns experienced during
the last 14 years, from 27 in 2000 to nearly 250 to date in 2014, in
addition to numerous undisclosed behind-the-scenes situations. Today,
regardless of industry, no company can consider itself immune from
potential activism. Indeed, no company is too large, too popular or too
successful, and even companies that are respected industry leaders and
have outperformed peers can come under fire. Among the major companies
that have been targeted are, Amgen, Apple, Microsoft, Sony, Hess, P&G,
eBay, Transocean, ITW, DuPont, and PepsiCo. There are more than 100 hedge
funds that have engaged in activism. Activist hedge funds have
approximately $200 billion of assets under management. They have become an
“asset class” that continues to attract investment from major traditional
institutional investors. The additional capital and new partnerships
between activists and institutional investors have encouraged increasingly
aggressive activist attacks.

The major activist hedge funds
are very experienced and sophisticated with professional analysts,
traders, bankers and senior partners that rival the leading investment
banks. They produce detailed analyses (“white papers”) of a target’s
management, operations, capital structure and strategy designed to show
that the changes they propose would quickly boost shareholder value. These
white papers may also contain aggressive critiques of past decisions made
by the target. Some activist attacks are designed to facilitate a takeover
or to force a sale of the target, such as the failed Icahn attack on
Clorox. Prominent institutional investors and strategic acquirors have
been working with activists both behind the scenes and by partnering in
sponsoring an activist attack such as CalSTRS with Relational in attacking
Timken, Ontario Teachers’ Pension Fund with Pershing Square in attacking
Canadian Pacific, and Valeant partnering with Pershing Square to force a
takeover of Allergan.

Many major activist attacks
involve a network of activist investors (“wolf pack”) who support the lead
activist hedge fund, but attempt to avoid the disclosure and other laws
and regulations that would hinder or prevent the attack if they were, or
were deemed to be, a group that is acting in concert. Not infrequently, at
the fringe of the wolf pack are some of the leading institutional
investors, not actively joining in the attack, but letting the leader of
the pack know that it can count on them in a proxy fight. Major investment
banks, law firms, proxy solicitors, and public relations advisors are now
representing activist hedge funds and are eagerly soliciting their
business.

Among the attack devices used by
activists are:

aggressively criticizing a
company’s announced initiatives and strategic actions and presenting the
activist’s own recommendations and business plan;

proposing a precatory proxy
resolution for specific actions prescribed by the activist or the
creation of a special committee of independent directors to undertake a
strategic review for the purpose of “maximizing shareholder value”;

conducting a proxy fight to
get board representation at an annual or special meeting or through
action by written consent (note that solicitation for a short slate is
very often supported by ISS and, if supported, is often successful, in
whole or in part, and ISS is increasingly showing support for “control”
slates);

orchestrating a “withhold the
vote” campaign;

seeking to force a sale by
leaking or initiating rumors of an unsolicited approach, publicly
calling for a sale, acting as an (unauthorized) intermediary with
strategic acquirers and private equity funds, making their own “stalking
horse” bid or partnering with a hostile acquirer to build secret,
substantial stock positions in the target to facilitate a takeover;

rallying institutional
investors and sell-side research analysts to support the activist;

using stock loans, options,
derivatives and other devices to increase voting power beyond the
activist’s economic equity investment;

using sophisticated public
relations, social media and traditional media campaigns to advance the
activist’s arguments;

litigating to obtain board
records and materials and to block transactions.

Current SEC rules do not prevent
an activist from secretly accumulating a more than 5% position before
being required to make public disclosure and do not prevent activists and
institutional investors from privately communicating and cooperating.

Prevention of, or response to,
an activist attack is an art, not a science. There is no substitute for
preparation. In addition to a program of advance engagement with
investors, it is essential to be able to mount a defense quickly and to be
flexible in responding to changing tactics. To forestall an attack, a
company should continuously review its business portfolio and strategy and
its governance and executive compensation issues sensibly and in light of
its particular needs and circumstances. Companies must regularly adjust
strategies and defenses to meet changing market conditions, business
dynamics and legal developments.

This outline provides a
checklist of matters to be considered in putting a company in the best
possible position to prevent or respond to hedge fund activism.

Advance Preparation

Create Team to Deal
with Hedge Fund Activism:

A small group (2-5) of key
officers plus lawyer, investment banker, proxy soliciting firm, and
public relations firm

Continuing contact and
periodic meetings of the team are important

A periodic fire drill with the
team is the best way to maintain a state of preparedness; the team
should be familiar with the hedge funds that have made activist
approaches generally and be particularly focused on those that have
approached other companies in the same industry and the tactics each
fund has used

Periodic updates of the
company’s board of directors

Shareholder
Relations:

The investor relations officer
is critical in assessing exposure to an activist attack and in a proxy
solicitation. The regard in which the investor relations officer is held
by the institutional shareholders has been determinative in a number of
proxy solicitations. Candid investor relations assessment of shareholder
sentiment should be appropriately communicated to senior management,
with periodic briefings provided to the board

Monitor peer group, sell-side
analysts, proxy advisors like ISS, activist institutions like CalSTRs
and TIAA-CREF, Internet commentary and media reports for opinions or
facts that will attract the attention of attackers

Be consistent with the
company’s basic strategic message

Objectively assess input from
shareholders—is the company receiving candid and direct feedback

Proactively address reasons
for any shortfall versus peer company benchmarks; anticipate key
questions and challenges from analysts and activists, and be prepared
with answers; build credibility with shareholders and analysts before
activists surface and attempt to “educate” the sell-side

Monitor changes in hedge fund
and institutional shareholder holdings on a regular basis; understand
the shareholder base, including, to the extent practical, relationships
among holders, paying close attention to activist funds that commonly
act together or with an institutional investor

Maintain regular, close
contact with major institutional investors; CEO, CFO and independent
director participation is very important; regularly engage with
portfolio managers as well as proxy-voting departments

Major institutional investors,
including BlackRock, Fidelity, State Street and Vanguard have
established significant proxy departments that make decisions
independent of ISS and GL and warrant careful attention. It is important
for a company to know the voting policies and guidelines of its major
investors, who the key decision-makers and point-persons are and how
best to reach them. It is possible to mount a strong defense against an
activist attack that is supported by ISS and GL and gain the support of
the major institutional shareholders

Maintain up-to-date plans for
contacts with media, regulatory agencies and political bodies and
refresh relationships

Continue regular temperature
taking calls pre- and post-earnings and conferences and exercise caution
and oversight with respect to large format or “group” investor meetings

Prepare the Board of
Directors to Deal with the Activist Situation:

Maintaining a unified board
consensus on key strategic issues is essential to success; in large
measure an attack by an activist hedge fund is an attempt to drive a
wedge between the board and management by raising doubts about strategy
and management performance and to create divisions on the board by
advocating that a special committee be formed

Keep the board informed of
options and alternatives analyzed by management, and review with the
board basic strategy, capital allocation and the portfolio of businesses
in light of possible arguments for spinoffs, share buybacks, increased
leverage, special dividends, sale of the company or other structural
changes

Schedule periodic
presentations by the lawyer and the investment banker to familiarize
directors with the current activist environment

Directors must guard against
subversion of the responsibilities of the full board by the activists or
related parties and should refer all approaches to the CEO

Boardroom debates over
business strategy, direction and other matters should be open and
vigorous but kept within the boardroom

Avoid being put in play;
recognize that psychological and perception factors may be more
important than legal and financial factors in avoiding being singled out
as a target

A company should not wait
until it is involved in a contested proxy solicitation to have its
institutional shareholders meet its independent directors. A
disciplined, thoughtful program for periodic meetings is advisable

Scrutiny of board composition
is increasing, and boards should self-assess regularly. In a contested
proxy solicitation, institutional investors may particularly question
the “independence” of directors who are older than 75 or who have served
for more than 10 to 15 years

Monitor parallel trading and
group activity (the activist “wolf pack”)

Monitor activity in options
and derivatives, as well as corporate debt and other non-equity
securities

The Activist White Paper

The activist may approach a
company with an extensive high-quality analysis of the company’s business
that supports the activist’s recommendations (demands) for:

Return of capital to
shareholders through share repurchase or a special dividend

Sale or the spin-off of a
division

Change in business strategy

Improvement of management
performance (replace CEO)

Change in executive
compensation

Change in cost structures

Merger or sale of the company

Change in governance: add new
directors designated by the activist, separate the positions of CEO and
Chair, declassify the board, remove poison pill and other shark
repellants, and permit shareholders to call a special meeting (or lower
thresholds for same) and act by written consent in lieu of a meeting

The white paper is used by the
activist in private meetings with shareholders, sell-side analysts and the
media and is ultimately designed for public consumption

Responding to an
Activist Approach

Response to
Non-Public Communication:

Assemble team and determine
initial strategy. Response is an art, not a science

No duty to discuss or
negotiate (no outright rejection, try to learn as much as possible by
listening and keep in mind that it may be desirable to at some point
negotiate with the activist and that developing a framework for private
communication and non-public engagement may avoid escalation)

No duty to disclose unless
leak comes from within

Response to any particular
approach must be specially structured; team should confer to decide
proper response

Keep board advised (in some
cases it may be advisable to arrange for the activist to present its
white paper to the board or a committee or subset of the directors)

No duty to respond, but
failure to respond may have negative consequences

Be prepared for public
disclosure by activist

Be prepared for the activist
to try to engage directly with shareholders, sell-side analysts,
business partners, employees and key corporate constituencies

Response to Public
Communication:

Initially, no response other
than “the board will consider and welcomes input from its shareholders”

Assemble team; inform
directors

Call special board meeting to
meet with team and consider the communication

Determine board’s response and
whether to meet with activist. Failure to meet may be viewed negatively
by institutional investors. Meeting may result in activist using the
meeting to mischaracterize the company’s position

Avoid mixed messages and
preserve the credibility of the board and management

Gauge whether the best outcome
is to agree upon board representation and/or strategic business or other
change in order to avoid a proxy fight

Be prepared and willing to
defend vigorously

Appreciate that the public
dialogue is often asymmetrical; while activists can, often without
consequence, make personal attacks and use aggressive language, the
company cannot respond in this manner

Remain focused on the
business; activist approaches can be all-consuming, but continued strong
performance of the business, though not an absolute defense, is one of
the best defenses. When business challenges inevitably arise, acting in
a manner that preserves and builds credibility with shareholders and
rest of investment community is of paramount importance. Maintain the
confidence and morale of employees, business partners and key
constituencies

The 2012 defeat by AOL of an
activist short-slate proxy solicitation supported by ISS shows that
investors can be persuaded to not blindly follow the recommendation of
ISS. When presented with a well-articulated and compelling plan for the
long-term success of a company, they are able to cut through the
cacophony of short-sighted gains promised by activists touting
short-term strategies. The AOL fight showed that when a company’s
management and directors work together to clearly present a compelling
long-term strategy for value creation, investors will listen

The recent amendments, and
then full withdrawal, by Carl Icahn of his attempt to force Apple into
leveraging its balance sheet and paying out $150 billion to its
shareholders, showed that investors can be convinced not to support an
activist attack that is not in the long-term best interests of the
company’s shareholders (Icahn later restated his support for continued
buybacks). In this connection, it is noteworthy that on March 21, 2014,
Larry Fink, Chairman and CEO of BlackRock, wrote to the CEOs of the S&P
500:

Many commentators lament
the short-term demands of the capital markets. We share those
concerns, and believe it is part of our collective role as actors
in the global capital markets to challenge that trend. Corporate
leaders can play their part by persuasively communicating their
company’s long-term strategy for growth. They must set the stage
to attract the patient capital they seek: explaining to investors
what drives real value, how and when far-sighted investments will
deliver returns, and, perhaps most importantly, what metrics
shareholders should use to assess their management team’s success
over time.

It concerns us that, in
the wake of the financial crisis, many companies have shied away
from investing in the future growth of their companies. Too many
companies have cut capital expenditure and even increased debt to
boost dividends and increase share buybacks. We certainly believe
that returning cash to shareholders should be part of a balanced
capital strategy; however, when done for the wrong reasons and at
the expense of capital investment, it can jeopardize a company’s
ability to generate sustainable long-term returns.

We do recognize the
balance that must be achieved to drive near-term performance while
simultaneously making those investments—in innovation and product
enhancements, capital and plant equipment, employee development,
and internal controls and technology—that will sustain growth.

BlackRock’s mission is
to earn the trust of our clients by helping them meet their
long-term investment goals. We see this mission as
indistinguishable from also aiming to be a trusted, responsible
shareholders with a longer term horizon. Much progress has been
made on company-shareholder engagement and we will continue to
play our part as a provider of patient capital in ensuring robust
dialogue. We ask that you help us, and other shareholders, to
understand the investments you are making to deliver the
sustainable, long-term returns on which our clients depend and in
which we seek to support you.

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